Description

HealthEquity recently completed an acquisition of WageWorks that will better position the Company for long-term growth and dominance in the HSA market, and allow HealthEquity to capture additional market share, add complementary products and distribution channels, and accelerate an industry transition to HSAs.

The WageWorks acquisition has fueled investor fears about slowing organic revenue growth at HealthEquity as the HSA industry matures.  At first glance, the acquisition seems to validate this fear: WageWorks’ top line growth (low-mid single digit) is significantly lower than HealthEquity (mid-teens), and the acquisition of WageWorks would dilute HealthEquity’s growth.  Since HealthEquity has historically traded at a premium valuation based on growth, a dilution of the Company’s growth profile and diversification out of HSAs frustrates many public market investors.

However, I believe the motivation for the transaction is not about diversifying product or revenue streams, but about grabbing more HSA market share in the end game at maturity.  The bigger picture is that at market maturity there will be 50-60mm HSAs and $1 trillion custodial assets.  While WageWorks’ 3% HSA market share is small today, I believes the platform’s future market share gain could be significant under HealthEquity leadership.  HealthEquity currently has 15% market share of HSA accounts but this represents 7% share of the HSA market at maturity. By acquiring WageWorks, HealthEquity becomes well positioned to capture an additional 20% of the end game market share.  As the HSA market matures and reaches $1 trillion in assets, holding an extra 20% market share for a capital-lite business is a big deal! 

In addition to building a strong foothold in the HSA market, I believe management’s cost synergies estimate is conservative because they understate the full impact of platform consolidation.  WageWorks was originally built up through a series of roll-up acquisitions resulting in various products operating across different legacy platforms.  Upon close, HealthEquity management intends to integrate and sunset these legacy platforms resulting in one platform operating for large enterprise customers and another for small companies.  An integration of the platforms will allow HealthEquity to remove a number of redundancies, personnel, locations, IT resources, etc. 

From my personal discussions with the Company, HealthEquity has stated there are additional expenses (e.g. geography, systems, platforms) that can be rationalized from WageWorks’ expense base but management has not publicly communicated these cost savings yet because the deal has not closed.  We can validate this by looking at precedent Platform as a Service transaction deals.  HealthEquity’s cost synergies target ($23mm) represents only ~5% of WageWorks’ revenue base (or 7% of consolidated operating expenses).  As shown in the chart below, management’s cost savings estimate seems low as only 1 deal going back to 2004 had cost savings at 5% with the average being ~10%.  More importantly, attained cost synergies in these precedent PAAS transactions often exceeded initial estimates. 

In 2018 and 2017, WageWorks generated $102mm and $72mm, respectively, in G&A expense, comprised primarily of personnel and related expenses and professional fees incurred by our executive, finance, legal, human resources and facilities departments.   When it comes to tech R&D, the company generated $53mm and $56mm in 2018 and 2017, respectively, which consisted of personnel and related expenses, outsourced programming services, on-demand technology infrastructure, and expenses associated with equipment and software development.  Ultimately, I believe the opportunity for additional synergies is great – if we were to assume 10% of revenue, that alone could add another $23mm of cost savings.

HealthEquity’s guided revenue synergy estimates represent only optimization enhancements that should contribute relatively quickly upon deal close.  However, management has deliberately excluded cross-selling and converting WageWorks’ FSA & HRA members to HSA. 

The cross-sell potential is quite significant: On a pro forma basis, HealthEquity would cover 2/3 of Fortune 500 companies and have 115k employer clients, reaching nearly up to 1/6 of the US workforce.  According to HealthEquity management, the revenue upside potential is 1.7-4x for clients that take on the full suite of products (based on survey of WageWorks’ top 2000 clients that have the full product stack).  Moreover, this clientele is severely underpenetrated as less than 5% of the combined employer partners have the full suite of HSA and complementary benefits. 

HealthEquity has significant cross-sell potential over WageWorks’ customer footprint.  WageWorks currently has relationships with ~70k different employers, of which less than 3% are using WageWorks for HSA administration.  This is because WageWorks had historically underinvested in its HSA business.  The history is WageWorks began as commuter business and then expanded into other CDB products but management neglected the HSA business.  A major product downfall has been the failure to integrate with health plans and obtain claims data, which prevented WageWorks from scaling its product to large platinum clients.  Moreover, customer service is poor and WageWorks management has openly admitted that HealthEquity’s HSA product is superior.

By combining with HealthEquity, WageWorks will become more competitive in HSAs, upgrading its product offering with best-in-class technology, brand recognition, customer service, and the ability to consolidate vendors down to one party.  With an upgraded HSA offering, I believe the product penetration potential is significant. In general, 25-30% of industry employers offer HSA plans vs. WageWorks which has only penetrated 3% of its ~70k employers. I believe many of WageWorks’ employer clients currently offer HSAs to their employees with another provider and simultaneously use WageWorks for other CDBs. 

An upgrade of WageWorks’ product platform provides an opportunity to steal market share from other HSA providers in the industry as WageWorks can present clients with an enhanced product offering that integrates HSAs and other CDBs into a single platform.  According to surveys of US private sector employers conducted by Aite Group in February 2019 and September 2016, 79% of employers would prefer to receive CDB administration from their HSA partner. 

Ultimately, I believe the cross-selling potential into WageWorks’ client base provides an opportunity for HealthEquity to double its number of HSA members, which would add nearly ~5mm HSA members and ~$10bn in custodial assets. 

In addition to cross-selling HSAs into WageWorks’ client base, HealthEquity could potentially convert a large number of WageWorks’ existing FSA/HRA members to HSA.  According to CEO Jon Kessler, there are significant similarities between small balance HSA accounts and FSAs/HRAs. HealthEquity has success in this domain convincing a large portion of its small balance HSA members to contribute and save more with their health savings accounts over time. 

HSAs are more profitable than FSA/CDB accounts.  As shown in the chart below, on a pro forma basis, the Company will have 11.7mm members, of which there are 4.8mm HSA members and 6.9mm participants in complimentary CDB products.  It is important to highlight that while WageWorks is the majority of revenue, HealthEquity represents the majority of EBITDA on less than half the revenues. HealthEquity is more profitable because it has more HSA exposure (85% of pro forma HSAs).  By converting WageWorks’ membership base to HSAs, the profitability of the combined franchise should improve. 

In addition to outperforming on synergy assumptions, I believe the transaction has deepened HealthEquity’s moat by taking up the Company’s market share.  Managing HSA accounts is extremely difficult without scale – subscale accounts require a lot of service (aka cost) upfront before members contribute enough funds to generate sufficient income to be profitable. 

In addition to improving the quality of the business, I believe the transaction should alter the valuation framework of the Company, which has created a misunderstanding among street analysts.  While growth will always be important, I believe the transaction makes adjusted EBITDA more significant. 

The long-term nature of merger/industry transformation also makes the stock difficult to value.  The correct year to anchor valuation should be 3-4 years out in CY 2022 (or FY 2023) for the following reasons:

• Cross Selling: With regards to cross-selling, HealthEquity will likely not see an impact in FY 2021 (CY 2020) but rather FY 2022 (or CY 2021) due to closing the transaction after the industry enrollment cycle ends.  The enrollment period happens once a year, and depending on when the transaction closes, it may be too late for open enrollment. Essentially, we are currently in FY 2020 right now, but most industry participants are already finishing up their plan design and enrollment.
  
  

• Synergies: Management believes cost synergies need 24-36 months to complete
  
  

• Capital Structure: HealthEquity is financing the transaction with new term loan debt which will need 3-4 years before the Company can fully delever and return to its historical unlevered state.  At close, leverage will be slightly under 4x and management intends to delever ~1x per year.

In 3-4 years, adjusted EBITDA would be growing mid 20s – At 1X EV/EBITDA PEG, that would translate to a 20x EV / 2022E EBITDA multiple, or $130 per share, representing a ~20%+ IRR from today’s price.  Yet, over the long run, it is not inconceivable that growth could re-accelerate. If HealthEquity is successful at cross-selling and converts a large portion of WageWorks members to HSAs, then growth could re-accelerate as HSA balances grow over time, prompting a valuation re-rating towards a growth multiple again.

Catalyst

Continued growth

Beating on consensus top & bottom line

Additional consolidation of HSA industry